Kaufman Signals

November 2017 Performance Report

Industry Benchmark Performance

A larger number of hedge fund managers are reporting results early this month, a sure sign that everything is going well. Equity Long programs are the real benchmark, and they were up 1.45% in November, about the same as our stock programs. For 2017 they have posted 12.59% higher, a nice return so far (but below our Daily Programs). Active management involve a strategy that can never capture all the profits if it is also going to manage the risk, so we think the industry is performing well thi year.

Futures are flat for 2017, but on the positive size. Our own Barclay Flash Report in October was slightly lower than the figures shown on the Barclays website, so there are always some late posting to these numbers.

Blogs and Recent Publications

Find this at the end of this report. We post new interviews and reference new articles each month.

November Performance in Brief

We’re still running to keep up with the S&P, and can see the whites of its eyes, but there is no thought to catching Nasdaq. Still, our stock Trend portfolios are up 17.85% and 19.01%, a respectable return in any year. The Divergence and Timing programs also posted good returns.

Weekly futures are making a comeback, up about 6% this month. Daily futures are having a stellar year, up 18% to 25%. The only program not doing well is Income Focus, which tends to run opposite to the equity market.

Major Equity ETFs. Recent days have been more volatile, given the pending vote on the new tax bill, as well as the yet unknown testimony of Michael Flynn. Given that, the stock market keeps going higher. Pundits have come around to acknowledging global growth as the reason, which we mention in this weeks “Up Close,” the next section. While the small caps, the Russell and IWM, have been floppy this year, they are still up by 15%, an altogether good return, overshadowed by Nasdaq, up nearly 32%. That should make for a Merry Christmas for someone.

Up Close: Christmas Cheer

2017 is turning out to be a surprising outperformance by all major indices. Through November, SPY is up 20.25%, the small-cap IWM up 15.04%, and Nasdaq QQQ up a remarkable 31.86%. A few years with returns like this wouldn’t hurt!

What can we expect in December? Last year we published a forecast on Seeking Alpha showing the history of December returns from 1950 (see Chart 1 below). Through 2016, there were only 14 of 66 years posting a loss. In December 2016 the SPX posted a gain of 1.82%. While average net gains are relatively small, there are a few big years.

Surprisingly, there doesn’t seem to be any relationship between performance from the beginning of the year and the December returns. The correlation for January and December returns for all the years was only 0.20, barely positive, and more likely the result of a market with an upwards bias.

Chart 1. Returns in December for SPX from 1950.

The gains through November this year are very strong, but investors are sensitive to whether the new tax bill will pass. We think it will. Whether it helps or hurts the middle class, it will help business by lowering the tax rate, which is all that matters in the stock market.

What’s driving the market? We have low unemployment and global growth is strong. Regulation has been cut back and there is a good chance of seeing lower corporate tax rates. We take the side of global growth being the biggest factor. U.S. politics can add volatility from day-to-day, but economic growth is the underlying upwards force.

A Christmas Rally?

Now let’s look at the December returns for more recent years using the SPDR ETF, SPY. One of the problems is aligning the data. We’ve decided that we would align the first 10 days, regardless of the day of week, and the last 10 days. In Chart 2, the bottom scale shows “-1” on the far right. That’s the last trading day of the year, regardless of day and regardless of date. The “-2” is the second trading day from the end of the year, and so on. We think this correctly represents the way we see the market.

Chart 2. Average returns for December by day from the beginning and from the end of the month.

Chart 3. SPY Returns from December 2016.

Chart 2 is very consistent for the two periods, 1998-2015 and 2011-2015. We can say that Christmas ends about five days before the end of the month which corresponds to the very end of the Christmas rally. Overall, we see December starting with some leftover optimism from Thanksgiving, but that fades after a week and is following by a reversal, perhaps the real liquidation. The Christmas rally is in force a week before Christmas and is strongest eight days before the end of the month.

Chart 3 shows that profits were made in the first 9 days of the month, then returned some of those gains during the rest of December.

The pattern through Christmas Day and a few days further seems to parallel how we think of everyone’s psychological mood. Good after Thanksgiving, tired of shopping in the middle of December, positive again going into Christmas week, and tired of everything after Christmas.

End-Of-Year Liquidation and Early January

History shows that the returns of the stock market fade during the last few days of the year, and 2016 was no exception. So, don’t expect anything to happen after Christmas Day.

Turning to January, Chart 4, we see a rally on the first day. It can’t be resetting of positions liquidated in December because any trade reset within 30 days would be considered a “wash trade” by the IRS. Overall, the beginning of January looks to be exhaustion after the holidays. The idea that “So goes January, so goes the year” is not something you should count on.

Chart 4. SPY Average returns (through 2016) for the first 10 days of January.

Chart 5. SPY returns for the first 10 days of January 2017.

In Chart 5 we see that The first 10 days of January 2016 were remarkably similar to the average. A gain in the first two days, followed by nothing. We should expect the same this year.

The Best Trade

We expect the economy to be good to us in December, but the stock market is not the economy. The stock market may react badly to a failed tax deal, but not do anything special if the new tax bill is passed. The market has some built-in gains from lower taxes, but the global economy will provide good support even while the tax legislation is left dangling. So, barring some upsetting news about taxes or geopolitical risks, we see the first half of December as good, and the last half as a slight loss. Much the same as history.

Portfolios Selected by Performance are High Beta

As a reminder, our automatic portfolio selection process uses past performance to select stocks and futures. Markets that are outperforming the averages tend to continue to outperform, but they also have higher volatility than the broad index. Outperformance means that profits on any day are higher, which also means that on a losing day, losses will usually be larger. It’s the basic principle of volatility and risk: you can’t achieve higher returns without higher risk.

Smaller portfolios that are less diverse are more likely to generate higher returns during “good” markets (the ones that work well for the strategy) and larger losses during “bad” markets. More diverse portfolios will have smaller gains and losses. To decide which is best for you, you must determine your risk tolerance and how much capital can be put at risk.

Trend Strength Index

One measure of market strength is our Trend Strength Index. Our Trend strategy is a composite of many trends, medium term to slow applied to about 275 stocks. When combined, these determine the position size of the current trade. If the faster trends are down but the slower one up, then the position size might be zero. The appearance is that trend positions scale in and out based on the strength of the trend. The Trend Strength Index appears at the bottom of the Trend Stocks All Signals report each day. We’ve tracked it from the beginning of 2014, and the chart below compares it with the SPY. TSI is the Trend Strength Index and SPY is the SPDR ETF.TSI values about zero indicate a positive trend. The range of the TSI is +1 to -1.

The Trend Strength Index reflects the internal strength (momentum) of all the stocks that we track, about 275. These stocks tend to have a stronger trend than the typical stock. It is also a mix of stocks from the S&P and Nasdaq, with a few smaller caps, but none trading fewer than an average of 1 million shares per day.

As long as the Trend Strength Index remains above zero, it expects higher prices in the SPY. The various dips from 40 to 20 don’t seem to be reflected in the SPY price unless you use a magnifying glass. The two larger dips in 2015 were a good leading indicator of a pullback in the major index, so we’ll just keep waiting. Meanwhile, the TSI doesn’t forecast any retracements.

We offer this Index for those investors who select their own trades rather than following our sample portfolios. Daily Index values are available to subscribers.

Strongest and Most Undervalued Sectors

There are two ways to view sector rotation, trade the strongest expecting them to stay strong, or trade the weakest expecting the business cycle to rotate them to the top. We have both. The Trend Rotation trades the strongest and the Timing Rotation trades the weakest. The Trend program may hold positions for a long time, so it’s possible for two ETFs to be in both programs. For example, XOP (Oil and Gas) can be in a long-term uptrend, but a short-term oversold situation. The new Sector Rotation program also buys the strongest sectors and is reviewed with the Trend Equity Program.

Strongest

The Trend Sector ETF program buys the 6 strongest sectors of the SPDRs.

When an ETF appears in both the Trend and Timing programs, it means that market is very strong but is in a short-term retracement.

A Standing Note on Short Sales

Note that the “All Signals” reports show short sales in stocks and ETFs, even though short positions are not executed in the portfolios. Our review of using inverse ETFs to hedge stocks during a decline showed that downturns in the stock market are most often short-lived and it is difficult to capture those moves with trend systems. This confirms our approach to the Timing systems, which hedges up to 50% of the long stock risk using multiple trends. In the long run, returns from the hedges are net losses; however, during 2008 the gains were welcomed and reduced losses. In any correction, we prefer paying for risk insurance, even without the expectation of a net gain.

Portfolio Methodology in Brief

All of the programs, stocks, ETFs, and futures, use the same basic portfolio technology. They all exploit the persistence of performance, that is, they seek those markets with good long-term and short-term returns, rank them, then choose the best, subject to liquidity, an existing current signal, with limitations on how many can be chosen from each sector. If there are not enough stocks or futures markets that satisfy all the conditions, then the portfolio holds fewer assets. In general, these portfolios are high beta, showing higher returns and higher risk, but have had a history of consistently out-performing the broad market index in all traditional measures.

PERFORMANCE BY GROUP

NOTE that the charts show below represent performance “tracking,” that is, the oldest results are simulated but the newer returns are the systematic daily performance added day by day. Any changes to the strategies do not affect the past performance, unless noted.

Groups DE1 and WE1: Daily and Weekly Trend Program for Stocks and ETFs, including Sector Rotation, Income Focus, and Dow Arbitrage

The Trend program seeks long-term directional changes in markets and the portfolios choose stocks and ETFs that have realized profitable performance over many years combined with good short-term returns.

Nice gains in all daily Trend Programs can be seen in the charts below. The ETF performance is accelerating to the upside, a good way to finish the year. While the stock programs are only slightly ahead of their long-term AROR, the ETF programs have doubled expectations this year.

Only the smaller, 10-stock Weekly Trend Portfolio is disappointing, up only about 12% this year, while the 30-stock portfolio is ahead by 17%. Both portfolios seem to be tracking the same, although we normally expect the 10-stock to have higher returns and higher volatility.

The Weekly ETF portfolios, similar to the daily ETF programs, are running well ahead of their long-term AROR and continue to recover from the 2015 drawdown.

Income Focus and Sector Rotation

Both daily and weekly Income Focus programs are flattening out as interest rate markets are uncertain. Both daily and weekly programs returned fractional losses and both have only small gains for the year.

The classic Sector Rotation program is down fractionally in November and up fractionally for the year, making it the most disappointing of all programs. While it still appears to be in a good uptrend in the chart below, it is moving with the speed of a snail.

DOW Arbitrage

Although this program only added 1% this month, it is now up 12.6% for 2017 with very steady performance.

Group DE2: Divergence Program for Stocks and ETFs

The Divergence program looks for patterns where price and momentum diverge, then takes a position in anticipation of the pattern resolving itself in a predictable direction, often the way prices had moved before the period of uncertainty.

Steady returns in all three Equity Divergence Programs keep the performance looking positive. This program is running slightly behind its long-term AROR.

Group DE3: Timing Program for Stocks and ETF Rotation

The Timing program is a relative-value arbitrage, taking advantage of undervalued stocks relative to its index. Its primary advantage is that it doesn’t depend on market direction for profits, although these portfolios are long-only because they are most often used in retirement accounts. When the broad market index turns down this program hedges part of the portfolio risk. The ETF Rotation program buys undervalued sectors, expecting them to outperform the other sectors over the short-term.

The Timing Program buys undervalued stocks so that it will buy the weakest even in a declining market until that stock shows that it is not expected to rally. Risk is protected with an absolute stop of 15% and also by hedging the broad index.

The Timing program is having an outstanding year, up about 3% to 4% this month in all three programs. The two equity portfolios are up 28% and 13% and ahead of their long-term AROR.

Futures Programs

Groups DF1 and WF1: Daily and Weekly Trend Programs for Futures

Futures allow both high leverage and true diversification. The larger portfolios, such as $1million, are diversified into both commodities and world index and interest rate markets, in addition to foreign exchange. Its performance is not expected to track the U.S. stock market and is a hedge in every sense because it is uncorrelated. As the portfolio becomes more diversified its returns are more stable.

The leverage available in futures markets allows us to manage the risk in the portfolio, something not possible to the same degree with stocks. This portfolio targets 14% volatility. Investors interested in lower leverage can simply scale all positions equally in proportion to their volatility preference. Note that these portfolios do not trade Asian futures, which we believe are more difficult for U.S. investors to execute.

Using the same strategy and portfolio logic, the Weekly Trend Program for Futures has the added smoothing resulting from looking only at Friday prices. While it will show a larger loss when the trend actually turns, most price moves are varying degrees of noise which this method can overlook.

Please read the report describing our revised portfolio allocation methodology. It can be found in the drop-down menu under “Articles.”

All six futures portfolios posted good returns in November. The Daily portfolios are oddly different due to their holdings. The smallest 250K is up 17%, while the 500K is only up 5% and the largest 1M is up 10%. Given a positive year for equities, a solid year for futures is welcome. The weekly programs had a better month, up over 6% in the 250K, 5.73% in the 500K, and 2.63% in the 1M. They are all running well behind their long-term AROR.

Group DF2: Daily Divergence Portfolio for Futures

The Divergence Futures program remains the outperformer this year, adding small gains to its year-to-date of 18% to 25%. While it has a volatile pattern, it continues to swing back to the upside with regularity.

Blogs and Recent Publications

There is a new interview on YouTube conducted by Alex Gerchik for his Russian audience. We haven’t viewed it yet, so it you see something odd, let us know! The link is:

Mr. Kaufman is participating in Jack Schwager’s FundSeeder webinar, to be announced soon.

Mr. Kaufman will be a speaker at the Money Show Expo in New York at the end of February.

He will give a 3-day seminar in Chicago, March 5-7, on developing a successful trading strategy, sponsored by the Chicago Institute of Investing. It will be in English and Chinese. For more information contact Katie.Tian@chicagoii.com.

Mr. Kaufman was a Keynote Speaker at the IFTA annual conference, hosted by the Swiss technical analyst’s association (SIAT) held in Milan, Italy, in October 12-16, 2017. A video of the presentation has been posted on the IFTA website.

“Portfolio Risk in Uncertain Times” was just posted on Seeking Alpha. It shows a better way to structure your portfolio. Prior to this, you will find “Living Off Profits,” which shows how much you can safely withdraw from your account without seeing spiral down out of control. Before that Seeking Alpha published “What Are the Odds?” a look at how to assess the risk of loss for any investment.

Technical Analysis of Stocks & Commodities will publish a two-part article on profit-taking and resets. The first part looks at trend following systems (in the January 2018 issue) and the second at short-term trading. Before that, they published “Optimization – Doing It Right,” in the September issue.

Modern Trader published “Dogging the Dow in the current edition, and a new article “Trading Opening Gaps” in stocks, scheduled for January 2018.

The IFTA Journal published an interview with Mr Kaufman in the most recent quarterly issue.

The broker FXCM will post a live interview with Mr Kaufman, taped on October 30.

ProActive Investor Magazine published Keeping Risk Under Control on June 22. Check their website. It will be publishing other articles later this year.

Andrew Swanscott at BetterSystemTrader.com (a good source for trading systems) has put up an edited version of an older presentation of Mr. Kaufman’s. It’s all about price noise and the Efficiency Ratio.